Bayer Ag

Bayer is shifting to the next phase of its development. The recent past has been dominated by the
integration of Schering and more recently by group-wide cost cutting. This process has been
accelerated somewhat in order to help mitigate the effects of the weak dollar. In 2008E,
restructuring will continue to be a driver of EPS growth. Looking further out, we believe it will be
the development of the Pharma portfolio that will play an increasing role in the value of the
shares. Portfolio change may also be a key driver given the synergies available from potential
healthcare consolidation, the low metrics accorded to pharma at present and the high valuation of
crop science assets. Furthermore, cash generation is likely to be very strong and without portfolio
change, the company could end 2010 with net debt of â¬2bn. This strong position would mean
acquisition firepower could be up to â¬20bn to finance external growth (depending on the cashflow
of any acquired asset).
With regard to organic growth prospects, there are three key points to note: 1) Bayer has a notable
patent challenge to its Yasmin franchise. Nonetheless, the overall generic risk is among the
lowest of all the large European pharma names over the next five years. This will help sustain
EBIT. 2) The R&D pipeline is starting to mature. On a risk-adjusted base, we see the products
currently in PII that are planned to move into PIII over the next 18 months together with the PIII
portfolio as worth about â¬15 per share. If Bayerâs development success proves to be in line with
the average, there is scope for a re-rating over this period. 3) Crop Science is booming at present
and this is likely also to be a significant contributor to incremental EPS growth.

The modest valuation metrics, solid EPS growth
and strong cashflow offer an attractive base. Should Bayer be able to develop
the potential of its pipeline in line with the pharma industry average, we believe
there is scope for sustained mid-term outperformance.

Valuation â Price Target Increased to â¬65

We believe fair value, based on a range of metrics, is somewhat over â¬70 per
share. This value tries to take into account the cyclicality of Materials, the
Pharma pipeline and the robust growth we believe Crop Science will deliver in
the medium term. Given the risks attached to the group and the uncertainties
surrounding drug development, we have set the price target at about a 10%
discount to our view of its fair value.